Primary function of oil is insulation. It provides the electrical insulation for parts of transformer. It insulates the windings from each other and from the core. The windings and core are separated by paper which is soaked by the oil. The advantage of oil insulation is that it heals up if it breaks down from an overvoltage. (The disadvantage is that it catches fire, leaks, and gradually get contaminated with carbon and moisture.)

Secondarily, the oil serves as a cooling medium to cool the transformer. Transformer oil remains stable at high temperatures over an extended period. To improve cooling of large power transformers, the oil-filled tank may have external radiators through which the oil circulates by natural convection. Very large or high-power transformers (with capacities of millions of watts) may also have cooling fans, oil pumps, and even oil-to-water heat exchangers.

Large, high-voltage transformers undergo prolonged drying processes, using electrical self-heating, the application of a vacuum, or both to ensure that the transformer is completely free of water vapor before the cooling oil is introduced. This helps prevent corona formation and subsequent electrical breakdown under load.

Oil filled transformers with conservators (an oil tank above the transformer) tend to be equipped with Buchholz relays. These are safety devices that can sense gas buildup inside the transformer (a side effect of corona or an electric arc inside the windings) and then switch off the transformer. Transformers without conservators are usually equipped with sudden pressure relays, which perform a similar function as the Buchholz relay.

The minimum flash point and maximum pour point are 140 degree Celsius and -6 degree Celsius respectively. The dielectric strength of new untreated oil is 30kV and after treatment it should be 60kV.

Large transformers to be used indoors must use a less-flammable liquid or be Dry Type, for instance, having no fluid.

Prior to about 1970, polychlorinated biphenyl (PCB) was often used as a dielectric fluid since it was not flammable. However, under incomplete combustion, PCBs can form highly toxic products, furans, etc. Due to the stability of PCB and its environmental accumulation, it has not been permitted in new equipment since late 1960's in the United States.

Today, non-toxic, stable silicone-based or fluorinated hydrocarbons are used, where the added expense of a fire-resistant liquid offsets additional building cost for a transformer vault. Natural or synthetic Esters are becoming increasingly common as alternative, to Naphthenic mineral oil too. Esters are non-toxic, readily biodegradable, and have higher flash points than mineral oil.